Introduction

Exchange Traded Funds (ETFs) were introduced in India in 2002 on the Nifty 50 Index. As of now, there are over 200 ETFs listed on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). ETFs represent a basket of securities that you can trade on the stock market, just like stocks. You can choose from two types of ETFs, namely active and passive ETFs. Both types have their own benefits and unique characteristics, such as how they are managed, costs involved, risk level, and objective to their performance. You need to understand these differences to make informed investment decisions and ensure the chosen ETF fits your portfolio.

In this article, you will learn what active and passive ETFs mean, their pros and cons, their differences, and which to choose to align with your investment goals.

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Understanding Active ETFs

An actively involved team of fund managers makes investment decisions to outperform the market or a specific index. They carry out the needed research and regularly employ multiple strategies to identify and invest in securities with the potential to generate high returns. Since these funds don’t aim to mimic a specific index, they are adept at quickly responding to dynamic market conditions and capitalising on emerging trends.

Understanding Passive ETFs

These funds aim to mimic the performance of an underlying index such as S&P 500 or Nifty 50 index etc. As the name suggests, these ETFs are managed passively and follow a buy-and-hold strategy. This reduces the overall expenses associated with maintaining a diversified portfolio and offers consistent returns, especially in the long run.

Pros and Cons of Active ETFs

Here are the benefits of investing in active ETFs.

• Backed by a professional fund management team, these ETFs capitalise on market trends to optimise your returns.
• The active involvement of the fund manager corresponds with enhanced flexibility needed to readjust your investment portfolio.
• In comparison to mutual funds or passive ETFs, active ETFs have the potential to generate higher returns for you.

The following are the drawbacks of active ETFs.

• You may have to pay higher costs due to active fund management, which leads to higher transaction costs.
• Since these ETFs can potentially outperform the market, you have to face higher associated risks.
• In comparison to passive ETFs, their transparency is low, so you get less frequent updates.

Pros and Cons of Passive ETFs

Here are the benefits of investing in passive ETFs.

• These ETFs use a consistent investment strategy, resulting in stable returns for you.
• Since their objective is to mirror the performance of an underlying index, even a single unit of this ETF offers you portfolio diversification.
• You can afford passive ETFs due to their low transaction and management costs.

The following are the drawbacks of passive ETFs.

• These are less flexible than active ETFs because they replicate the composition of an underlying index.
• These are ideal if you are a risk-averse long-term investor, unlike those interested in profiting from intraday trading facilitated by active ETFs.

Active vs Passive ETFs: What to Choose?

The return and risk involved are two primary factors influencing your decision to choose between active and passive ETFs. Let’s see how active and passive ETFs fare in this regard.

A fund’s objective and the prevailing market condition influence the returns. The fund managers in active ETFs actively scout for profitable investments. These ETFs can generate high returns for you when the market is volatile by leveraging the market trends. However, you can get steady returns in passive ETFs by replicating their benchmark’s performance. In stable markets, passive ETFs will give you better and steady returns.

Your risk tolerance and market volatility determine investment risk. Risk and reward are proportional. As the risk increases, so does your potential reward. Active ETFs are a better fit if you are a risk-taking investor due to their active management strategies, which are dependent on market volatility. On the other hand, passive ETFs are good if you are a lower-risk investor, since they track well-established benchmarks.

Ultimately, the answer to the question, “Should you choose passive or active ETFs?” boils down to understanding your risk tolerance, investment horizon, and investment goals. Active ETFs are an ideal choice if you have a short investment horizon and are willing to accept the potential of underperformance for higher returns. However, passive ETFs are ideal if you are a risk-averse long-term investor seeking steady returns.

Conclusion

If you want to settle the debate about which ETFs to choose—active or passive—you need to consider your risk tolerance, the market conditions, and your investment goals. As with any other form other investment, passive and active ETFs have pros and cons. Regardless of what you choose, you get instant exposure to a diversified portfolio of stocks instead of investing in individual ones.

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